European Economics – week 2

Optimum Currency Area

Important topics:
• Optimum Currency Area
• Costs/Benefits common currency
• Asymmetrical shocks
• Adjustment mechanisms

BW Chapter 15 - no IS-MP-IRP framework !

 Optimum Currency Area

= Geographical area where the benefits of a common

currency exceed the costs
 Common currencies
Not only the EU, also Africa
Argentina, Luxemburg

UEMOA = Union économique et

monétaire ouest-africaine

CEMAC = Communauté
Économique et Monétaire de
l'Afrique Centrale

CFA-franc = Franc des Colonies

Françaises d'Afrique
 OCA

Is the Eurozone an OCA?

Are benefits > costs ?
 Benefits of an OCA

Direct benefits:
- Reduction of transaction costs (1/4 - ½% GDP)

Indirect benefits:
- Reduction price discrimination  more competition
- Reduction of uncertainty
- More transparancy  more competition
 Benefits common currency

- Less transaction costs

- Less price discrimination (due to more transparency)
- Reduction of (exchange rate) uncertainty

Benefits increase as a country has more international

trade
 Costs of a common currency

What are the costs of a common currency?

Loss of monetary policy
One size fits all = One size fits none

Why is this a problem?

Countries are different 
Have different needs with respect to monetary policy
 Costs of a common currency

Therefore:
Real costs of a single currency reveal themselves in
situations where monetary adjustments are desirable
 Situation: Shift in demand

Assumptions:
• 2 countries: France and Germany
• 1 good : cars
• International trade
• Both countries have their own currency (FF and DM)
• Both countries in equilibrium (full employment)
• Shock: Reduction of demand for French cars
Increase in demand for German cars
 Begin situation
France Germany
Pf Pg
Sf Sg

Df
Dg

Yf Yg
 Begin situation
France Germany
Pf Pg
Sf Sg

Df Dg

full employ Yf full employ Yg

 Shift in demand
France Germany
Pf Pg
Sf Sg

Df Dg

Yf Yg
 Shift in demand
France Germany
Pf Pg
Sf Sg

Df Dg

Yf Yg

Output gap Output gap

 Consequences:
France Germany

• demand Fr cars  • demand German cars 

• Unemployment in export sector • Inflation P 

U

• Deficit Trade balance • Surplus Trade balance

(Export – import < 0) (Export – import > 0)

Both countries are in disequilibrium!

 How to adjust?
German products must become more expensive
French products must become cheaper:

A monetary adjustment is by far the most easy solution

Floating exchange rate: Automatic adjustment

Demand FF ↓ → value FF ↓
Demand DM ↑ → value DM ↑
 How to adjust?

Fixed exchange rate

Devaluation French Frank

Revaluation Deutsch Mark
 Effect of revaluation of the DM
France Germany
Pf Pg
Sf Sg

Df
Dg

Yf Yg
 In a currency union:
no exchange rate adjustments

Adjustment must take place through adjustments in

labour and goods market

• France: unemployment  wages w  prices p 

• Germany: tight labour market  w  p 

 Adjustment of supply
No exchange rate adjustment
France Germany
Pf Pg
Sf Sg

Df
Dg

Yf Yg
 Adjustment of supply
No exchange rate adjustment
France Germany
Pf Pg
Sf Sg

Df
Dg

Yf Yg
Lower wages => supply curve shifts to the right
Higher wages => supply curve shifts to the left
 Adjustment of supply
France Germany
Pf Pg
Sf Sg

Df
Dg

FE Yf FE Yg
Full employment (FE) is restored in both countries
 Other adjustment mechanisms:

1. Mobility of labour
Unemployed French  Germany

2. Fiscal transfers (fiscal union)

Taxes in Germany   France (Länder-ausgleich)

3. wage flexibility
Fr: U  W more supply  supply-curve to the
right
Du: P  W less supply  supply curve to the
left
EU Labour mobility
Budget transfers Länder
 Problems eurozone:

1. Monetary policy: one size does not fit all

2. Fiscal policy tied to 3% rule SGP

3. Wage flexibility and labour mobility low

4. No budget transfers (no policital union)

 Insufficient ‘shock absorbers’

 Asymmetrical shocks

Problem: asymmetrical shocks

Shock which have different, usually adverse, effects on
various economies involved

Costs of common currency:

• Unemployment in France
• Inflation in Germany
 Costs: shocks in Monetary Union

Problem for EMU: Asymmetrical shocks

• No monetary policy ECB possible

Symmetrical shocks: monetary policy is possible

 Requires business cycles are synchronized
 Synchronous economic cycles
Germany

(GDP)

time
 Synchronous economic cycles
Germany

(GDP)

time
Upward trend (economic growth) determined by
technological progress
 Synchronous economic cycles
Ger

(GDP)
Output gap

time
 Synchronous economic cycles
Ger

(GDP)

time
 Synchronous economic cycles
Ger
NL

(GDP)

time
 Synchronous economic cycles
Ger
NL

y Be

(GDP)

tijd
 Fig 17.2
Why does this happen?
p. 424
 synchronous cycles
Thus:
The more international trade:
→ The more synchronized business cycle
→ more insensitive to asymmetric shocks
→ more effective monetary policy
→ lower the cost of a common currency
 OCA-criteria (§ 15.4 p.361-368 )

Decline of costs of OCA when countries have:

1) High degree of labor mobility (Mundell)

2) High degree of "openness" (McKinnon)
3) Export is diversified (Kenen)
4) Fiscal transfers take place (budget transfers)
5) Homogeneous (policy) preferences
6) Solidarity vs. nationalism
4-6 are political choices !!
Marginal costs and benefits

Fig. 15.2
p. 352
 Is the EU an OCA?

partly

Tabel 15.1 p. 376

 Conclusion:
Monetary Union requires:

•Sufficient wage flexibility

•Sufficient labour mobility
•Preferably also centralized fiscal policies
(i.e. political union)
 Conclusion:
Which countries can form a monetary union?

1) Countries with a high level of bilateral trade

(go through the same economic cycles)

2) Countries that are similar in terms of economic

structure

3) Countries that have the political will to form a

monetary union
End